On several occasions I have written about how some of my clients have amassed a tidy retirement fund by moving into rental properties they owned, living there at least 2 years to establish those homes as their own personal residences, and then selling them and keeping $250,000 of their profit for a single person or $500,000 for a married couple, tax free, as long as they living in the home at least 2 of the 5 years immediately preceding the sale. I have clients who have done this as many as 4 times, thus accumulating $2 million, tax free, towards their retirement.
Well, that was then, and this is now. The tax reformers on Capitol Hill have taken notice of this huge tax loophole and they are shutting it down. For properties purchased after Jan. 1, 2009, the rules for rental properties that are later converted into personal residences have changed. The new rules factor in the number of years you have rented the property and discount that factor from the tax exemption. Here is an example:
On Jan. 2, 2009 you purchase a second home or investment property. You rent out the property for 8 years, then move into it and live there for 2 years. Towards the end of the second year, you put the property up for sale and close escrow right at the end of your 2 year eligibility period. So, for all intents and purposes you owned the property for 10 years, rented it for 8 of those 10, and then lived in it for 2. Let's say your profit (basically what you sold it for less what you paid for it, buying and selling expenses, and capital improvements) is $120,000. During the rental period you wrote off $20,000 in depreciation. Under the old rules the $20,000 you depreciated during the rental period would be treated as gross income. All of the remaining $100,000 profit would be tax free.
Under the new rules, the $20,000 would still be treated as gross income (no change there.) But only a portion of the remaining $100,000 would be tax free, depending on how long you rented the property vs. how long you used it as your personal residence. The rest will be taxed as capital gains.
To calculate how much falls into each category, divide the number of years that you did not live in the property (8 years) by the number of years you owned the property. In this case that would be 8/10 or 80% of $100,000. That amount ($80,000) is subject to capital gains treatment. Only the remaining 20% ($20,000) will be completely tax free. (This assumes that you lived in the property 2 of the 5 years immediately preceding the sale, as in this example. It does not have to be the 2 years immediately preceding the sale.)
If you move into the rental property and never sell it during your lifetime, there is no problem. But if you are thinking of buying property in an area you think you want to retire to you really should do it NOW. In many areas of the country it is a solid buyer's market, a great opportunity to purchase property while prices are low and there is plenty to choose from. Eventually appreciation will kick back in and by the time you retire your dream home may be out of reach. But don't wait until next year. If you do move there as planned and you change your mind later, for any reason, it can make a huge difference in how much money you can walk away with!!
© Lynne Mercer, August 16, 2008